English Court Rules on ISDA® Master Agreement Section 2(a)(iii) in Lomas and Other Cases | Practical Law

English Court Rules on ISDA® Master Agreement Section 2(a)(iii) in Lomas and Other Cases | Practical Law

The Court of Appeal of England and Wales considered Section 2(a)(iii) of the ISDA Master Agreement in four highly anticipated appeals: Lomas v. JFB Firth Rixson; Lehman Brothers Special Financing Inc. v. Carlton Communications; Pioneer Freight Futures v. Cosco; and Britannia Bulk v. Pioneer Navigation.

English Court Rules on ISDA® Master Agreement Section 2(a)(iii) in Lomas and Other Cases

by PLC Finance
Published on 04 Apr 2012 • England, Wales
The Court of Appeal of England and Wales considered Section 2(a)(iii) of the ISDA Master Agreement in four highly anticipated appeals: Lomas v. JFB Firth Rixson; Lehman Brothers Special Financing Inc. v. Carlton Communications; Pioneer Freight Futures v. Cosco; and Britannia Bulk v. Pioneer Navigation.
On April 3, 2012, the Court of Appeal of England and Wales issued judgments in four highly anticipated appeals, including the Lomas and others v. JFB Firth Rixson Inc. and others case, that hinged on interpretation of Section 2(a)(iii) of the ISDA® Master Agreement (ISDA Master). Under Section 2(a)(iii), each payment obligation under the agreement is subject to the condition precedent that no event of default has occurred and is continuing with respect to the counterparty otherwise entitled to receive the payment.
In its ruling, the Court of Appeal agreed with submissions by ISDA, the publisher of the ISDA Master, that following an event of default, Section 2(a)(iii) has the effect of suspending (potentially indefinitely) the non-defaulting party's payment obligations until the default is cured or the non-defaulting party terminates the transaction. This ruling cements a transatlantic disparity in interpretation of this provision, as the Southern District of New York Bankruptcy Court ruled in the Lehman v. Metavante case that where the defaulting counterparty is in bankruptcy, the agreement must be terminated "promptly" by the non-defaulting party or the right to terminate may be waived.
In a consolidated case, the Court of Appeal heard four appeals:
  • Lomas and others v. JFB Firth Rixson Inc. and others. The lower court hearing this case held that Section 2(a)(iii) has the effect of suspending (while the event of default is continuing) rather than extinguishing the payment obligations of the non-defaulting party, but only until the transaction expires, at which time the payment obligation would be extinguished. The Court of Appeal dismissed the appeal, disagreeing with the lower court on the question of the extinction of the payment obligation upon maturity of the transaction. The Court of Appeal agreed with submissions by ISDA that following a default, these payment obligations remain suspended (potentially indefinitely) until the default is cured or the non-defaulting party elects to terminate the transaction (at which time the amounts would be due and owing as part of the early termination payment). But, the Court of Appeal held, the payment obligations are not extinguished by reason of maturity of the transaction. For information on early termination payments under an ISDA Master, see Practice Note, Comparison of 1992 and 2002 ISDA Master Agreements: Section 6(e) Methodology for Payment upon Early Termination.
  • Lehman Brothers Special Financing Inc. v. Carlton Communications Ltd. The lower court followed its earlier decision in Lomas and confirmed it could not read into the ISDA Master a provision specifying that payments due under an ISDA Master to a defaulting party are suspended only for a reasonable time, or that a non-defaulting party is under an obligation to designate an early termination date to terminate the transactions under the ISDA Master. The Court of Appeal agreed and dismissed the appeal.
  • Pioneer Freight Futures Company Ltd. v. Cosco Bulk Carrier Company Ltd. Like the lower court in Lomas, the lower court in Pioneer Freight held that payment obligations suspended by Section 2(a)(iii) do not survive the natural expiry date of a transaction. Those transactions would therefore not be "outstanding transactions" within the meaning of Section 6(a) of the ISDA Master or transactions "in effect" within the definition of "Terminated Transactions" in the 1992 ISDA Master. Suspended payments due under these transactions therefore would not be eligible to be included in the close-out amount calculations under Section 6(e) of the ISDA Master following automatic early termination under the ISDA Master. The Court of Appeal allowed the appeal and held that transactions that have final payment dates falling before the early termination date can be included in close-out amount calculations.
  • Britannia Bulk plc v. Pioneer Navigation Ltd. and others. The lower court held that a non-defaulting party could rely on Section 2(a)(iii) of a 1992 ISDA Master Agreement to formulate a "nil loss" argument against a defaulting party's claim for payment of close-out amounts due under terminated ISDA Master transactions. The Court of Appeal disagreed and dismissed the appeal.
In dismissing all but one of the appeals, the Court of Appeal agreed with submissions made by ISDA that, following an event of default, Section 2(a)(iii) has the effect of suspending (potentially indefinitely) the non-defaulting party's payment obligations until the default is cured or the non-defaulting party elects to terminate the transaction.
This ruling contrasts with a US ruling on this matter, as the Southern District of New York Bankruptcy Court ruled in the Metavante case that a non-defaulting party's rights to terminate an ISDA Master Agreement under Section 2(a)(iii) must be exercised "promptly" after the occurrence of the event of default or it may be deemed to have been waived (see Legal Update, Lehman Court Ruling in Metavante Matter Expected to Complicate Withholding Payments Under Derivatives Contracts). Following the UK rulings, ISDA issued a press release welcoming the judgment, an indication that it disagrees with the US holding in Metavante. Note that Metavante only applies when the defaulting counterparty is the subject of US bankruptcy proceedings. Any US party subject to an extended uncured event of default under an ISDA Master, however, is likely to be the subject of bankruptcy proceedings.
The UK cases are important in the US because they may impact the choice of law that a counterparty may prefer when entering into an ISDA Master. Broker-dealers and banks that are swap dealers may prefer the UK holding under which they can continue to withhold payments indefinitely in the event of a counterparty default. This allows an out of the money non-defaulting counterparty to attempt to take advantage of swings in the market to improve its position before terminating the agreement (at which time an early termination payment is due from the out of the money party to the in the money party, in the aggregate, under all transactions entered into under that ISDA Master).
For more information about Section 2(a) of the ISDA Master Agreement, see the following resources:
Court Documents:
  • Lomas and others (together, the Joint Administrators of Lehman Brothers International (Europe)) v. JFB Firth Rixson Inc and others [2012] EWCA Civ 419 (03 April 2012).
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